This Document Contains Chapters 14 to 21 14 Capital Markets Author's Overview This chapter on capital markets is basic to the understanding of the flow of funds through the economy and the relationship of capital markets to corporate bonds, stocks, and preferred stock. Students often view bonds as uninteresting and unimportant securities, so special emphasis has been placed on them to show their dominant positions as a source of external capital. The instructor may wish to stress the point that corporations do not operate in a vacuum but in a competitive capital market with government units. Although much of this chapter is descriptive, it reinforces the concepts of risk and return and wealth maximization by describing the markets that create wealth and either reward or penalize the investor for assuming risk. The allocation of capital in a capitalistic economy is crucial to the understanding of our economic system, and the instructor will wish to point out the role of the securities markets in this allocation process. Also, the ever increasing role of international capital markets should be stressed. The collapse of Asian currencies during 1997 and 1998 and the Russian government debt default are examples of how the international markets are linked as well as the collapse of Argentina in 2002. The Financial Crisis that began in 2007 and continued into 2013 affected economies worldwide. Housing prices fell in the U.S. and Europe, and unemployment rose to very high levels. Commercial banks had to be recapitalized, and many European countries were in economic trouble and had to be supported by the European Union and the International Monetary Fund. The Dow Jones Industrial average fell by more than 50 percent but recovered all of its losses by August of 2013. Markets and currencies were affected by the turmoil in the Middle East. There is much to discuss about how international markets are linked. The changing nature of securities markets can be seen by the decimalization of our markets. Additionally, the traditional markets are meeting competition from electronic communication networks (ECNs). Changes in our market structure will continue to be motivated by competition and technology. We have taken the opportunity to include a section on market efficiency. There is a discussion of efficiency in the more traditional sense of liquidity, stability, and continuity, and this is linked with the concept of the efficient markets hypothesis in the weak, semi-strong and strong forms. The important matter of securities market regulation is also covered in the chapter. Chapter Concepts LO1. The capital markets, both domestic and foreign, are made up of securities that have a life of one year or longer (often much longer). LO2. The primary participants raising funds in the capital markets are the U.S. Treasury; other agencies of the federal, state, and local governments; and corporations. LO3. The United States is a three-sector economy in which households, corporations, and governmental units allocate funds among themselves. LO4. Securities markets consist of physical and electronic markets. LO5. Security markets are considered to be efficient when prices adjust rapidly to new information. LO6. Security legislation is intended to protect investors against fraud, manipulation, and illegal insider trading. Annotated Outline and Strategy Perspective 14-1: Though this is a descriptive chapter, the institutional relationships are important to students who have had limited experience with capital markets. I. Introduction A. Money market: Short-term market for securities maturing in a year or less. B. Capital market: Long-term market for securities with maturities greater than one year. C. More often, companies search all capital markets including world markets for capital at the lowest cost. II. International Capital Markets A. Competition for low cost funding is worldwide. B. Important developments in international capital markets include NAFTA (1994); creation of the European Monetary Union and European Central Bank (1999); the growth of the World Trade Organization (WTO) with the admission of Russia in 2012 as one of the 160 member countries; and the rise of China as the world’s second largest economic power. C. The economic development of emerging markets has increased the size of these markets as a percentage of the world’s publicly traded capital. D. Money flows between countries include U.S. investment abroad and foreign investments in the U.S. III. Competition for Funds in the U.S. Capital Market Perspective 14-2: Explain that finding financial capital is a competitive game. Companies compete among themselves, the federal government, and state governments. A. Government Securities 1. The U.S. Treasury borrows both long-term and short-term debts to cover budget deficits. When budget surpluses exist, as they did in 1998, the government reduces its net borrowing. 2. Large amounts of long-term capital in the United States have been supplied by foreigners. Foreign investors have been attracted by the relatively high interest rates and political stability available in the United States. 3. Federally sponsored credit agencies, charged with funding the large numbers of federal programs, issue securities in the capital markets. Agencies such as the Federal National Mortgage Association, the Federal Home Loan Banks, the Farm Credit Banks, has varied widely but has been rising in percentage terms as the U.S. Treasury has no need to finance large deficits by selling U.S. government securities. 4. State and local municipalities are usually required by law to balance their budgets so their borrowing is often short-term or project related. The interest paid on these issues is exempt from federal income tax. B. Corporate Securities 1. New issues of corporate securities have been predominantly bonds in recent years. Bonds are more widely used to raise capital when interest rates are low. 2. Though very similar to debt, the lack of the tax deductibility of preferred stock dividends has constrained the popularity of preferred stock issues. 3. New issues of common stock mushroomed in the late 1990s as the dot.com craze swept the IPO market. 4. The majority of internally generated funds are not included in reported earnings. Depreciation tax shields provide a substantial source of internal funding. The percentage relationship between retained earnings and depreciation varies over time based on profits and capital spending patterns, but depreciation is usually a very substantial source of internally generated funds. PPT Internally generated funds: Depreciation and retained earnings (Figure 14-2) IV. The Supply of Capital Funds PPT Flow of Funds through the Economy (Figure 14-3) PPT Suppliers of Funds to Credit Markets (Year-End, 20011) (Figure 14-4) Finance in Action: The World’s Biggest Exchange: Hatched from an Egg? This box describes the formulation and evolution of the futures market. What began as a marketing technique to guarantee prices on eggs and butter has become the largest exchange in the world (The CME Group) trading over 1.2 quadrillion dollars each year. A. Business and government have been net demanders of funds and the household sector the major supplier of funds in our three-sector economy. B. Household sector savings are usually channeled to the demanders of funds through financial institutions such as commercial banks, savings and loans, mutual savings banks, and credit unions. See Figure 14-2 for the major suppliers of U.S. credit market funds. C. Other intermediaries in the flow-of-funds process include mutual funds, pension plans, and insurance firms. D. The Role of the Security Markets 1. Securities markets aid the allocation of capital between the sectors of the economy and the financial intermediaries. 2. Security markets enable the demanders of capital to issue securities by providing the necessary liquidity for investors in two ways: a. Corporations are able to sell new issues of securities rapidly at fair competitive prices. b. The markets allow the purchaser of securities to convert the securities to cash with relative ease. Perspective 14-3: Explain that financial markets are continually changing over time as technology advances. V. The Organization of the Security Markets A. In addition to the traditional national and regional securities exchanges which provide a centrally located auction market for buyers and sellers, the globalization of markets and investments is fueling the need for electronic communication networks (ECNs) to improve efficiency and lower trading costs. B. Traditional Organized Exhanges 1. The primary U.S. exchanges are the New York Stock Exchange (NYSE) and NASDAQ. 2. Exchanges of lesser importance include the Midwest, Pacific, Detroit, Boston, Cincinnati, and PBW (Philadelphia, Baltimore, and Washington) exchanges. Ninety percent of the volume on these regional Exchanges is from dually traded stocks on the NYSE. 3. For a firm to sell its stock on one of these exchanges, it must meet the listing requirements of that exchange. C. Electronic Communications Networks (ECNs) 1. Electronic trading systems that use computers to automatically match buy and sell orders. 2. ECNs lower the cost of trading by creating better execution, more price transparency and by allowing “after hours trading.” 3. Once thought to be in competition with the traditional exchanges, they are now used by the established exchanges as part of their operating strategy. D. New York Stock Exchange (NYSE) 1. The NYSE is the largest and most important global stock exchange. 2. To be listed on the NYSE, firms must meet certain minimum requirements pertaining to earnings power, level of assets, market value and number of shares of publicly-held common stock, and the number of shareholders. See the web exercise at the end of the chapter. 3. Beginning in August 2000, U.S. security markets started trading in decimals rather than fractions. Market-makers generally prefer the wider spreads guaranteed with fractions, but investors appear to have benefited from decimalization. 4. In 2005, the NYSE purchased Archipelago, an electronic communication network (ECN) which competes with traditional floor trading. It is argued that ECNs will eventually dominate floor trading due to greater efficiency. 5. In 2006, the NYSE merged with Euronext in order to expand its international scope. 6. In 2012 the Intercontinental Exchange (ICE) agreed to buy the NYSEEuronext Exchange, and as of July 2013 had received permission from the European Union. It appears the deal will go through. E. The NASDAQ Market – NASDAQ is a purely electronic market with no central location. 1. The NASDAQ market is a national network of dealers. 2. Dealers own the securities they trade and seek to earn a profit from their buying and selling, whereas brokers receive a commission as an agent of the buyer or seller of securities. 3. The NASDAQ market includes the National Market, which includes larger firms of national interest, and the Small-Cap Market for smaller companies, many of which are of regional interest. F. Numerous stock exchanges operate outside the United States. These exchanges trade stocks in of companies in their own domestic market, as well as stocks of large U.S. companies. Many foreign stocks are also traded in U.S. markets. G. The National Association of Securities Dealers (NASD) regulates brokers and dealers in all U.S. markets. The NASD writes rules governing broker and dealer behavior and polices its members. H. Foreign Exchanges 1. These are shown in Table 14-1. I. Other Financial Exchanges 1. Consist mostly of futures, commodity and options exchanges. VI. Market Efficiency A. Criteria of Efficiency 1. Rapid adjustment of prices to new information 2. Continuous market; successive prices are close 3. Market is capable of absorbing large dollar amounts of securities without destabilizing the price. B. The more certain the income stream, the less volatile price movements will be and the more efficient the market will be. C. Screen based trading systems versus floor trading is becoming a trend that most observers would agree increase market efficiency. D. The efficiency of the stock market is stated in three forms. 1. Weak form: Past price information is unrelated to future prices; trends cannot be predicted and taken advantage of by investors. 2. Semi-strong form: Prices reflect all public information. 3. Strong form: Prices reflect all public and private information. E. A fully efficient market, if it exists, precludes insiders and large institutions from making profits from security transactions in excess of the market in general. F. The efficiency of the market is debatable but most would agree that the movement is toward greater efficiency. VII. Regulation of the Security Markets A. Organized securities markets are regulated by the Securities and Exchange Commission (SEC) and through self-regulation. The OTC market is regulated by the National Association of Securities Dealers (NASD). B. Three major laws govern the sale and trading of securities. 1. Securities Act of 1933: This act was a response to abuses present in the securities markets during the Wall Street "Crash" era. Its purpose was to provide full disclosure of all pertinent investment information on new corporate security issues. 2. The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC) and empowered it to regulate the securities markets. 3. The Securities Acts Amendments of 1975 directed the SEC to supervise the development of a national securities market, prohibited fixed commissions on public transactions, and prohibited financial institutions and insurance companies from buying stock exchange memberships to save commission costs. 4. The Sarbanes-Oxley Act of 2002 authorized an independent private-sector board to oversee the accounting profession. The act was in response to the many accounting frauds perpetrated on investors by companies such as Enron, World Com, and Tyco. 5. In 2010 Congress passed the Dodd-Frank: Wall Street Reform and Consumer Protection Act. This is the most comprehensive financial reform legislation since the Great Depression. This act impacts banks, hedge funds, derivatives, credit cards, mortgages, and other financial products. It is an extremely complex law, and as of late 2013 it had many rules that were not yet defined and put into action. Finance in Action: When Pleading Ignorance Didn’t Work—The Case of Bernie Ebbers and WorldCom, Inc. This box discusses WorldCom’s demise due to the largest accounting fraud in U.S. history. Mr. Ebbers’ principal defense was that, although he ran the huge multinational corporation, he had no expertise in accounting. Although Ebbers was convicted, his behavior and his claims that he was financially unsophisticated were important motivations for passage of the Sarbanes-Oxley Act. Investment Banking: Public and 15 Private Placement Author's Overview This chapter presents a detailed account of the functions of the investment banker. By making maximum use of material covered under the "distribution process," the instructor can present a good picture of the marketing channels and pricing mechanisms that are frequently utilized in a public distribution. Such topics as the underwriter spread, pricing of the security, market stabilization, and after-market considerations are usually interesting to the student. We highlight the Facebook IPO and its subsequent price collapse. The book was printed in summer of 2013 when Facebook finally regained its original IPO price of $38. You may want to focus on the three parts of Table 15-1 to highlight the concentration of the investment banking market and the various segments of the market shown in part B and part C. The advantages and disadvantages of going public is an area worthy of consideration. While it seems that the ultimate goal of every small firm is to grow large enough to one day be public, there are some very sound reasons to challenge this objective. The continuing importance of private placement and its impact on traditional investment banking can be considered. Also, the instructor should cover the phenomenon of the leveraged buy-out, a significant development of the 1980s that has continued to this day. Chapter Concepts LO1. Investment bankers are intermediaries between corporations in need of funds and the investing public. They also provide important advice. LO2. Investment bankers, rather than corporations, normally take the risk of successfully distributing corporate securities and for this there are costs involved. LO3. Distribution of new securities may involve dilution of earnings. LO4. Corporations turn to investment bankers and others in making the critical decision about whether to go public (distribute their securities in the public markets) or stay private. LO5. Leveraged buy-outs rely heavily on debt in the restructuring of a corporation. Annotated Outline and Strategy I. Introduction: The late 1990s may well be called the dot.com era for investment banking, as record numbers of companies from Amazon.com to eBay went public. Emphasis on this phenomenon is a great way to make this chapter interesting from the start. Additionally the IPO by Google featured in the last Finance in Action Box and the IPO by Facebook highlighted later can create some interest in this chapter. II. The Role of Investment Banking A. The role of investment banking has been to act as the middleman between investors with money and companies in need of capital. B. Investment bankers have been merging and the industry has consolidated to the point where the top 10 underwriters controlled 51.1 percent of the global market by 2012. C. Note the diverse areas of debt, equity, global, and domestic shown in table 15-1 parts A, B, C. Also examine part C to demonstrate that various investment bankers dominate individual segments of market. PPT Underwriters, markets, and rankings (Table 15-1, Parts A-B-C) D. In 1999 Congress passed the Gramm-Leach-Bliley Act which repealed the GlassStegal Act. The Glass-Stegal Act required that commercial banks and investment banks operate independently of each other. While the investment banking market was already competitive, Gramm-Leach-Bliley allows combinations between investment banks and commercial banks. Note that Citigroup and JP Morgan, two of the leading security underwriters, also own two of the three largest U.S. commercial banks, Citibank and Chase, respectively. E. Competition is keen among investment bankers and many limit themselves to specific segments where their reputation and expertise is highest. III. Enumeration of Functions A. Underwriter: The risk-taking function. The underwriter bears the risk of fluctuations in the selling price of the security issue. The investment banker may handle the issues of unknown corporations on a nonrisk-bearing "best efforts" basis only. B. Market maker: The investment banker may engage in buying and selling of a security to ensure an available market. C. Advising: Corporations may seek an investment banker's advice on the size, timing, and marketability of security issues. Advice is also rendered pertaining to merger and acquisition decisions, leveraged buyouts, and corporate restructuring. D. Agency functions: As an agent, the investment banker assists in the private placement of security issues and in the negotiating process of merger and acquisition transactions. Perspective 15-1: Further explain that Merrill Lynch, now a part of Bank America, and other Wall Street firms are financial conglomerates providing a variety of services. IV. The Distribution Process A. The managing investment banker forms an underwriting syndicate of investment bankers to increase marketability of the issue and spread the risk. B. Syndicate members, acting as wholesalers, sell the securities to brokers and dealers who eventually sell the securities to the public. PPT Distribution Process in Investment Banking (Figure 15-1) C. The spread is the difference in the price of a security to the public and the amount paid to the issuing firm and represents the compensation of those participating in the distribution. 1. The spread is divided among the distribution participants. The lower a party falls in the distribution hierarchy, the lower the portion of the spread received. 2. Usually, the larger the dollar value of an issue, the smaller the spread. 3. The spread on equity issues is greater than on debt issues because of the greater price uncertainty. PPT Allocation of Underwriting Spread (Figure 15-2) V. Pricing the Security A. Several factors must be considered by the managing investment banker when negotiating the issue price of a security of a first-time issuer. 1. Experience of the firm in the market. 2. Financial position of the issuing firm. 3. Expected earnings and dividends. 4. P/E multiples of firms in the same industry. 5. Anticipated public demand. Finance in Action: Warren Buffett’s Bailout of Goldman Sachs At the peak of the financial crises of 2008, Berkshire Hathaway stepped in to rescue Goldman Sachs by buying $5 Billion worth of preferred stock and warrants to buy $5 billion of common stock at $115 per share. The influx of cash not only helped Goldman Sachs avoid financial collapse but actually increased the stock price from $113 to $176; a healthy benefit for both parties. Buffett actually traded in his warrants for 9.2 million shares of stock in March of 2013. Have your students research the transaction on Google. Perspective 15-2: Investment bankers take price risk and are motivated to price issues conservatively to sell out the issue. Corporations want the highest price possible. This potential conflict may create interesting situations and is worthy of discussion. B. The issue price of securities of firms with existing securities outstanding is usually determined by "underpricing." 1. Price is set slightly below current market value. 2. Underpricing is partially a result of the dilutive effect of spreading earnings over a greater number of shares of stock. C. Dilution: When new common stock is sold, the new shares issued immediately cause earnings per share to decline until the earnings can be increased from the investment of new funds. D. Market Stabilization. The managing investment banker seeks to stabilize the market (keep the sales price up) by repurchasing securities while at the same time selling them. Note that the SEC recognizes that underwriter price support is a form of market manipulation, but the practice is allowed as a justifiable element of smoothly functioning IPO markets. Perspective 15-3: The stabilization process for the Facebook IPO is highlighted by Figures 15-3 and 15-4. E. Aftermarket: Research has indicated that initial public offerings often do well in the immediate aftermarket. However, average long-run returns for IPOs appear to be relatively poor. F. Shelf Registration 1. Large companies are permitted to file one comprehensive registration statement and then wait (hold securities on a shelf) until market conditions are favorable before issuing securities without further SEC approval. Previously, a registration statement had to be filed for each security issue. Shelf registration has been used primarily for debt issues. 2. A greater concentration of business among the stronger firms in the investment banking industry has resulted from the shelf registration process. VI. Public versus Private Financing A. Advantages of being public 1. Greater availability of funds 2. Prestige 3. Higher liquidity for stockholders 4. Established price of public issues aids a stockholder's estate planning 5. Enables a firm to engage in merger activities more readily B. Disadvantages of being public 1. Company information must be made public through SEC and state filings 2. Accumulating and disclosing information is expensive in terms of dollars and time 3. Short-term pressure from security analysts and investors 4. Embarrassment from public failure 5. High cost of going public 6. Sarbanes-Oxley requirements have added additional burdens VII. Public Offerings A. A classic example: Rosetta Stone goes public 1. Table 15-4 shows the costs of issuance including the following fees: SEC registration fee, FINRA filing fee, initial NYSE listing fee, legal fees and expenses, accounting fees and expenses, printing expenses, transfer agent and registrar fees and expenses, and miscellaneous expenses. 2. Figure 15-6 demonstrates what often happens after an IPO. Large shareholders decide to sell more shares after the IPO. The increased supply of shares and the negative signal that large shareholders are exiting the stock sends the price down. VIII. Private Placement. Private placement refers to selling securities directly to insurance companies, pension funds, and others rather than going through security markets. Private placement is used more for debt than equity issues. A. Advantages and disadvantages of private placements 1. Advantages a. Eliminates the lengthy, expensive registration process with the SEC b. Greater flexibility in negotiating terms of issue c. Costs of issue are less 2. The usually higher interest cost on a privately placed debt instrument is a disadvantage. Perspective 15-4: Discuss the consequences for public markets if the trend to utilize private placement increases. Finance in Action: Tulip Auctions and the Google IPO This box describes how Google went public using a Dutch auction rather than the standard methods discussed in this chapter. Google’s decision was driven, at least in part, by a desire to avoid under pricing its stock in the offering. Dutch auctions are used extensively for Treasury auctions, but IPOs are rarely priced in this manner. Google’s IPO was underpriced anyway. However, underwriter fees were only 2.8%, which is certainly less than a traditional IPO would have cost the firm. Also, Dutch auctions appear to remove at least some to the disadvantages faced by small investors in the traditional IPO process. B. Going Private and Leveraged Buyouts 1. Firms that elect to go private are usually small companies that are seeking to avoid large auditing and reporting expenses. In the 1980's, however, large firms have been going private to avoid the pressure of pleasing analysts in the short term. There are two basic ways to go private. The public firm can be purchased by a private firm or the company can repurchase all publicly traded shares from the stockholders. 2. Many firms have gone private through leveraged buyouts. Management or some external group borrows the needed cash to repurchase all the shares of the company. Frequently the management of the private firm must sell off assets in order to reduce the heavy debt load. 3. Several firms that have gone private during the 1980s have restructured and returned to the public market at an increased market value. In some cases the firm was divided and the divisions were sold separately. The "breakup value" of some firms such as Beatrice and Uniroyal was substantially higher than the market value of the unified entity. IX. International Investment Banking Deals A. Privatization: Beginning in the 1980s and continuing today, many governments around the world are selling state-owned companies to individual and institutional investors. China is probably the current leader in this activity as the communist country tries to create large publicly-owned companies that can become more efficient through the pressure of being compared to other publicly traded companies in its competitive industry. Markets do have a way of rewarding successful companies and penalizing underperforming ones. Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 22, Robert Boyle & Associates, Inc. (Going Public and Investment Banking) Case 23, Glazer Drug Co. (Initial Public Offering) 16 Long-Term Debt and Lease Financing Author's Overview This chapter covers a broad range of debt topics including secured versus unsecured debt, sinking fund provisions, bond prices, yields, ratings, and conversion and call features. The student gets a good indoctrination into the various influences on bond prices, which can be strongly reinforced by problems at the back of the chapter. Table 16-3 summarizes various points about bond pricing such as coupon rate versus market rate and the influence of bond ratings. The bond refunding decision is covered from the approach of a capital budgeting problem and leasing is examined as a special form of debt, rather than as a separate type of financing. Studies and pronouncements by the accounting profession have taken the authors in this direction. However, the reasons for a lease arrangement are clearly enumerated. Additional material on the lease versus purchase decision is also covered in Appendix 16B. Financial alternatives for distressed times are covered in Appendix 16A, with a discussion of outof-court and in-court settlements. Disposal of assets under liquidation are also examined in this appendix. Chapter Concepts LO1. Analyzing long-term debt requires consideration of the collateral pledged, method of repayment, and other key factors. LO2. Bond yields are important to bond analysis and are influenced by how bonds are rated by major bond rating agencies. LO3. An important corporate decision is whether to call in and reissue debt (refund the obligation) when interest rates decline. LO4. Long-term lease obligations have many characteristics similar to debt and are recognized as a form of indirect debt by the accounting profession. LO5. When a firm fails to meet its financial obligations, it may be subject to bankruptcy. Annotated Outline and Strategy I. The Expanding Role of Debt Perspective 16-1: The expanding role of debt is not just an issue for corporations but also for federal and state governments and consumers. A. Corporate debt has expanded dramatically in the last three decades. B. The rapid expansion of corporate debt is the result of: 1. Rapid business expansion. 2. Inflation. 3. At times, inadequate funds generated from the internal operations of business firms. 4. Repurchase of common stock with cheap debt. C. Corporations suffered a decline in interest coverage until 2008. Although the financial crisis had a dramatic affect on financial institutions most corporations suffered a temporary decline in earnings. As earnings rebounded and they refinanced debt at low interest rates, their earnings coverage ratios rebounded to record levels. PPT Times Interest Earned for Standard & Poor’s Industrials (Figure 16-1) II. The Debt Contract A. Par value: the face value of a bond B. Coupon rate: the actual interest rate on a bond; annual interest/par value C. Maturity date: the final date on which repayment of the debt principal is due D. Indenture: lengthy, legal agreement detailing the issuer's obligations pertaining to a bond issue. The indenture is administered by an independent trustee. E. Security provisions 1. Secured claim: specific assets are pledged to bondholders in the event of default. 2. Mortgage agreement: real property is pledged as security for loan. 3. Senior claims require satisfaction in liquidation proceedings prior to junior claims. 4. New property may become subject to a security provision by an "after acquired property clause." F. Unsecured debt 1. Debenture: an unsecured, long-term corporate bond 2. Subordinated debenture: an unsecured bond in which payment will be made to the bondholder only after the holders of designated senior debt issues have been satisfied. G. Methods of Repayment 1. Lump: sum payment at maturity 2. Serial payments: bonds are paid off in installments over the life of the issue; each bond has a predetermined maturity date. 3. Sinking fund: the issuer is required to make regular contributions to fund under the trustee's control. The trustee purchases (retires) bonds in the market with the contributions. 4. Conversion: retirement by converting bonds into common stock; this is the option of the holder but it may be forced. (See Chapter 19.) 5. Call Feature: an option of the issuing corporation allowing it to retire the debt issue prior to maturity. It requires payment of a call premium over par value of 5 percent to 10 percent to the bondholder. The call is usually exercised by the firm when interest rates have fallen. PPT Priority of Claims (Figure 16-2) H. An Example: Eli Lilly’s 6.77 Percent Bond. (See Table 16-1) III. Bond Prices, Yields, and Ratings A. Bond prices are largely determined by the relationship of their coupon rate to the going market rate and the number of years until maturity. 1. If the market rate for the bond exceeds the coupon rate, the bond will sell below par value. If the market rate is less than the coupon rate, the bond will sell above par value. 2. The more distant the maturity date of a bond, the farther below or above par value the price will be given the coupon rate and market rate relationship. PPT Bond Price Table (Table 16-2) PPT Long-Term Yields on Debt (Figure 16-3) B. Bond yields are quoted on three different bases. Assume a $ 1,000 par value bond pays $100 per year interest for 10 years. The bond is currently selling at $900 in the market. Perspective 16-2: It is important for students to understand the difference between the various bond yields. The most important yield is the yield to maturity which is a function of price change as well as annual cash flow. 1. Coupon rate (nominal yield): Stated interest payment divided by par value $100/$1,000 = 10% 2. Current yield: Stated interest payment divided by the current price of the bond, $100/$900 = 11.11% Perspective 16-3: You may want to refer to the material on page 308 in Chapter 10 that demonstrates the calculation of yield to maturity using an Excel spreadsheet or calculator keystrokes. The approximate yield to maturity calculation demonstrates the impact on YTM when the bond sells at a premium or discount. 3. Yield to Maturity: the interest rate that will equate future interest payments and payment at maturity to current market price (the internal rate of return). The yield to maturity may be computed approximately by the following formula. C. Bond ratings 1. There are two major bond-rating agencies: Moody's Investor Service and Standard and Poor's Corporation. 2. The higher the rating, the lower the interest rate that must be paid. 3. The ratings are based on: a. the firm's ability to make interest payments. b. consistency of performance. c. firm size. d. the firm’s debt/equity ratio. e. the firm’s working capital position. f. and other factors. D. Examining actual bond ratings: See Table 16-3 and discussion. IV. The Refunding Decision A. The process of calling outstanding bonds and replacing them with new ones is termed refunding. This action is most likely to be pursued by businesses during periods of declining interest rates. B. Interest savings from refunding can be substantial over the life of a bond but the costs of refunding can also be very large. Perspective 16-4: Compare the refunding decision with paying off a high-cost mortgage early and refinancing it at a lower rate with all the resultant costs of financing, points, closing fees, lawyers, etc. C. A refunding decision is nothing more than a capital budgeting problem. The refunding costs constitute the investment. The net reduction in annual cash expenditures are the inflows. 1. Outflow Considerations: a. The after tax cost of the call premium b. The Underwriting Cost on the new issue less the PV of the future tax savings (on the new underwriting cost) 2. Inflow Considerations: a. The present value of the after tax savings on the difference in the interest rates b. Tax benefit from the immediate write off of the remaining unamortized underwriting cost of old issue. (The difference between immediate write off of remaining value and the PV of annual write off times the tax rate.) 3. Net Present Value: Inflows minus outflows equals Net Present Value. PPT Restatement of Facts D. A major difference in evaluating a capital expenditure for refunding is that the discount rate applied is the aftertax cost of debt rather than the cost of capital because the annual savings are known with greater certainty. PPT Net Present Value V. Other Forms of Bond Financing A. Zero-Coupon Rate Bonds 1. Do not pay interest; sold at deep discounts from face value. 2. These bonds provide immediate cash inflow to the corporation (sell bonds) without any outflow (interest payments) until the bonds mature. 3. Since the difference between the selling price and the maturity value is amortized for tax purposes over the life of the bond, a tax reduction benefit occurs without a current cash outflow. 4. Allows investor to "lock-in" a multiplier of the initial investment. 5. Most investors in these bonds are tax exempt because the annual increase in bond value is taxed as ordinary income even though no payment is received. 6. Brokerage houses are marketing future interests in government securities which are a variation of the zero-coupon rate bond. PPT Zero-Coupon and Floating Rate Bonds (Table 16-4) B. Floating Rate Bonds 1. The interest rate varies with market conditions. 2. Unless market rates move beyond floating rate limits, the price of the floating rate bond should not change, therefore, the investor is assured (within limits) of the market value of his investment. Advantages and Disadvantages of Debt A. Benefits of Debt 1. Tax deductibility of interest. 2. The financial obligation is specific and fixed (with the exception of floating rate bonds). 3. In an inflationary economy, debt may be repaid with "cheaper dollars." 4. Prudent use of debt may lower the cost of capital. B. Drawbacks of Debt 1. Interest and principal payments must be met when due regardless of the firm's financial position. 2. Burdensome bond indenture restrictions. 3. Imprudent use of debt may depress stock prices. C. Eurobond Market 1. Usually denominated is dollars but not always. 2. Disclosure less stringent then U.S. Securities and Exchange Commission. 3. Not able to rely on rating agencies. 4. See examples in Table 16-6. PPT Examples of Eurobonds (Table 16-5) VI. VII. Leasing as a Form of Debt A. A long-term, noncancellable lease has all the characteristics of a debt obligation. B. The position of the accounting profession that companies should fully divulge all information about leasing obligations was made official for financial reporting purposes in November, 1976. The Financial Accounting Standards Board (FASB) issued Statement No. 13. 1. Prior to FASB Statement No. 13, lease obligations could be disclosed in footnotes to financial statements. 2. FASB No. 13 requires that certain types of leases be shown as long-term obligations on a firm's financial statements. C. Leases that substantially transfer all the benefits and risks of ownership from the owner to the lessee must be capitalized. A capital lease is required whenever any one of the following conditions exists. 1. Ownership of the property is transferred to the lessee by the end of the lease term. 2. The lease contains a bargain purchase price (sure to be purchased) at the end of the lease. 3. The lease term is equal to 75 percent or more of the estimated life of the leased property. 4. The present value of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property at the beginning of the lease. D. A lease that does not meet any of the four criteria is an operating lease. 1. Usually short-term. 2. Often cancelable at the option of the lessee. 3. The lessor frequently provides maintenance. 4. Capitalization and presentation on the balance sheet is not required. E. Impact of capital lease on the income statement 1. The intangible leased property under capital lease (asset) amount is amortized and written off over the life of the lease. 2. The obligation under capital lease (liability) is written off through amortization with an "implied" interest expense on the remaining balance. F. Advantages of leasing 1. Lessee may not have sufficient funds to purchase or borrowing capability. 2. Provisions of lease may be less restrictive. 3. May be no down payment. 4. Expert advice of leasing (lessor) company. 5. Creditor claims on certain types of leases are restricted in bankruptcy and reorganization procedures. 6. Tax considerations a. Obtain maximum benefit of tax advantages. b. Tax deductibility of lease payments for land. 7. Infusion of capital through a sale-leaseback. VIII. Appendix 16A: Financial Alternatives for Distressed Firms A. Financial Distress 1. Technical Insolvency-firm has positive net worth but is unable to pay its bills as they come due. 2. Bankruptcy-a firm's liabilities exceed the value of its assets-negative net worth. B. Out-of-Court Settlements 1. Extension-creditors allow the firm more time to meet its financial obligations. 2. Composition-creditors agree to accept a fractional settlement on their original claim. 3. Creditor committee-a creditor committee is established to run the business in place of the existing management. 4. Assignment-a liquidation of the firm's assets without going through formal court action. C. In-Court Settlements-Formal Bankruptcy 1. Bankruptcy proceedings may be initiated voluntarily by the firm or forced by the creditors-involuntary bankruptcy. 2. The decisions of a court appointed referee who arbitrates the bankruptcy proceedings are final subject to court review. 3. Reorganization-a fair and feasible plan to reorganize the bankrupt firm. a. Internal reorganization necessitates an evaluation of existing management and policies. An assessment and possible redesign of the firm's capital structure is also required. b. External reorganization-a financially strong and managerially competent merger partner is found for the bankrupt firm. 4. Liquidation-if reorganization of the firm is determined to be infeasible; the assets of the firm will be sold to satisfy creditors. The priority of claims is: a. Bankruptcy administrative costs (legal fees) b. Wages of workers earned within 3 months of bankruptcy declaration c. Federal, state and local taxes d. Secured creditors-designated assets e. General creditors-there is a priority within this category also f. Preferred stockholders g. Common stockholders IX. Appendix 16B: Lease versus Purchase Decision A. Leasing as a means of financing is often compared to borrow-purchase arrangements when assets are to be acquired. This procedure is particularly appropriate for comparing an operating lease to purchasing. B. The present value of all after-tax cash outflows associated with each form of financing is computed. The procedure requires consideration of all tax shields for each method. Since all outflows are fixed by contract, the discount rate employed in computing the present value of the outflows is the after-tax cost of debt. C. Although qualitative factors must be considered, the usual decision criterion is to accept the financing method (lease, or purchase) which has the lowest present value of cash outflows. The cash inflows should be the same whether the asset is leased or purchased. Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 24, Leland Industries (Debt Financing) Case 25, Warner Motor Oil Co. (Bond refunding) 17 Common and Preferred Stock Financing Author's Overview The first part of the chapter gives the student a clear view of the changing nature of stock ownership through increasing institutional participation and the declining importance of individual stock ownership. The residual nature of common stock as compared to other securities is examined as well as cumulative voting and rights offerings. We also stress the various classes of common stock that exist, such as voting and non-voting and founders stock. Preferred stock should be introduced as a hybrid form of security. The unusual tax features of preferred stock are compared to debt by highlighting the non-tax deductibility of preferred dividends to the paying corporation and the partial tax-exempt nature of preferred dividends to corporate owners. The cumulative nature of preferred stock is also important to the discussion, with lesser recognition given to the conversion, call, and participating features (some of these topics have been covered under the discussion of debt). Chapter Concepts LO1. Common stockholders are the owners of the corporation and therefore have a claim to undistributed income, the right to elect the board of directors, and other privileges. LO2. Cumulative voting provides minority stockholders with the potential for some representation on the board of directors. LO3. A rights offering gives current stockholders a first option to purchase new shares. LO4. Poison pills and other similar provisions may make it difficult for outsiders to take over a corporation against management's wishes. LO5. Preferred stock is an intermediate type of security that falls somewhere between debt and common stock. Annotated Outline and Strategy I. Introduction A. Although management controls the corporation on a daily basis, ultimate control of the firm resides in the hands of the stockholders. B. Common stockholders poses three key rights: the residual claim to income, the right to vote and elect the board of directors, and the right to purchase new shares to maintain their ownership percentage. . II. Common Stockholders’ Claim to Income A. Common stockholders have a residual claim on the income stream; the amount remaining after creditors and preferred stockholders have been satisfied belongs to the owners (common stockholders) whether paid in dividends or retained. B. Institutional investors such as pension, mutual funds, exchange traded funds, insurance companies, and bank managed trust funds control a large share of the voting power. C. A corporation may have several classes of common stock that differ in regard to voting rights and claim on the earnings stream. PPT Institutional Ownership of U.S. Companies (Table 17-1) III. The Voting Right A. Owners of common stock have the right to vote on all major issues including election of the board of directors. Perspective 17-1: The voting right is important, and the Ford family provides an interesting example of “founders’ stock” for students. B. Majority voting: holders of majority of stock can elect all directors. C. In some firms such as Ford Motor Company, different classes of stock are entitled to elect a specified percentage of the board of directors. D. Cumulative voting makes it possible for minority stockholders who own less than 50 percent of the stock to elect some of the directors. 1. The stockholder can cast one vote for each share of stock owned times the number of directors to be elected. 2. The following formula may be employed to determine the number of shares needed to elect a given number of directors under cumulative voting. Number of Total number of Shares directors desired shares outstanding = + 1 required Total number of directors to be elected + 1 3. Restated, if we know the number of minority shares outstanding under cumulative voting and wish to determine the number of directors that can be elected, we use the formula: Number of directors (Shares owned − 1) (Number of directors to be elected + 1) = that can be elected Total number of shares outstanding Finance in Action: Morningstar Gives Hewlett-Packard a Stewarship Rating of Poor This box discusses how corporate boards of directors are responsible for the major strategic decisions of a company. According to Morningstar, a financial analysis firm, HP senior management and the board have failed to provide consistent quality leadership for the company. This comprehensive box is quite instructive and can be tied back to Chapter 1 and the section on corporate governance. IV. The Right to Purchase New Shares A. The stockholder may have the right to maintain his percentage of ownership, voting power, and claim to earnings through the preemptive right provision which requires that existing stockholders be given the first option to purchase new shares. Rights offerings are more common in European markets than in the U.S. Perspective 17-2: The Ericsson offering in August of 2002 is an example of a major rights offering. See Table 17-2 for other examples. B. The Use of Rights in Financing 1. Even if the preemptive right provision is not required, the corporation may finance through a rights offering. 2. Each stockholder receives one right for each share of stock owned, and is allowed to buy new shares of stock at a reduced price (below market value) plus the required number of rights/share. 3. The number of rights required to purchase a new share equals the ratio of shares outstanding to the new shares issued. Number of rights required Number of shares outstanding = to purchase one new share Number of shares to be issued 4. Rights have market value since they entitle the holder to purchase shares of stock at less than market price. a. Rights Required: Initially, after the rights offering announcement, stock trades "rights-on." The formula for the value of a right during the rights-on period is: R = (M S0 − ) (N 1)+ M0 = Market value of stock, rights-on S = Subscription price N = Number of rights required to purchase a new share of stock b. Monetary Value of a Right: After a certain period, the right no longer trades with the stock but may be bought and sold separately. On the "ex-rights" date the stock price falls by the theoretical value of a right. The ex-rights value of a right is: R = (M Se − ) N Me = Market value of stock, ex-rights Perspective 17-3: Rights provide a first option to purchase new shares but do not make the stockholder wealthier. 5. Existing stockholders usually do not have a monetary gain from a rights offering. The gain from purchasing shares at less than market price is eliminated by dilution of previously owned shares. 6. A stockholder has three options when presented with a rights offering. a. Exercise the rights; no net gain or loss b. Sell the rights; no net gain or loss c. Allow the rights to lapse; a loss will be incurred due to the dilution of existing shares that is not offset by value of unsold or unexercised rights. C. Desirable features of rights offerings 1. Protects stockholders' voting position and claim on earnings 2. Existing stockholders provide a built-in market for new issues; distribution costs are lower 3. May create more interest in stock than a straight offering 4. Lower margin requirements Finance in Action: HSBC Holdings Plc. Rights Offering HSBC Holdings Plc. also know as Hong Kong Shanghai Banking Corporation, is Europe’s biggest bank with a worldwide presence. This box describes how they used a $17.7 billion rights offering in March of 2009 to bail themselves out of the financial crisis. This is one of the largest rights offerings in history. D. Poison Pills 1. A "poison pill" is a rights offering made to existing shareholders of a company with the sole purpose of thwarting an acquisition attempt by another company. The increased number of shares may dilute the ownership percentage of the firm pursuing the takeover. 2. Some investors feel that a poison pill strategy is contrary to the goal of maximizing the wealth of the owners. V. American Depository Receipts (ADRs) A. ADRs are shares of foreign stock held in trust by U.S. Banks that issues a claim on these trust receipts. There are over 700 ADRs listed on the NYSE, NASDAQ and the AMEX. See Table 17-3 for the list of regions and markets. B. ADRs allow foreign companies to raise funds in U.S. markets and provide investors with English annual reports using U.S. GAAP accounting. C. The example of ADRs gives the professor yet another chance to emphasize how important international markets are to both U.S. and foreign firms. VI. Preferred Stock Financing A. Characteristics of preferred stock 1. Stipulated that dividends must be paid before dividends on common stock but are not guaranteed or required. 2. Dividends are not tax-deductible. B. Preferred stock contributes to capital structure balance by expanding the capital base without diluting common stock or incurring contractual obligations. C. Primary purchasers of preferred stock are corporate investors, insurance companies and pension funds primarily because 70 percent of dividend income received by corporations is exempt from taxation whereas interest received is fully taxable. VII. Provisions Associated with Preferred Stock A. Cumulative dividends B. Conversion feature C. Call feature D. Participation provision E. Floating rate F. Dutch Auction Preferred Stock G. Par value VIII. Comparing Features of Common and Preferred Stock and Debt: As the level of risk increases, so does the return. PPT Features of Alternative Security Issues (Table 17-4) PPT Risk and Expected Return for Various Security Classes (Figure 17-1) Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 26, Midsouth Exploration Company (Preferred Stock) Case 27, Alpha Biogenetics (Poison Pill) 18 Dividend Policy and Retained Earnings Author's Overview The key initial question to be asked is: How does a corporation determine the amount of dividends to be paid? The discussion should move to the marginal principle of retained earnings with the associated emphasis on dividends as a passive variable in the decision-making process. The corporate life-cycle curve is included to relate growth to dividend policy. Because few students would accept the theory that a corporation sets its dividend payment entirely on the basis of whether the corporation or stockholder can make a higher return on the funds, the passive approach to dividends is seen as a good but incomplete theory that must be supplemented with further considerations. The instructor can then cover other relevant functions of dividends such as resolution of uncertainty and information content, and integrate the marginal principle of retained earnings with considerations of investor preferences. Other influences on dividend policy such as legal requirements, cash position of the firm, access to capital markets, and the like are presented. Additional material is also provided on dividend payment procedures and dividend reinvestment plans. Cash dividends are now a more attractive alternative then they once were. The 2003 tax act reduced the dividend tax rate to 15 percent and the tax act of 2013 kept this rate for taxpayers with taxable income of less than $450,000.. Stock repurchase as an alternative to the cash dividend has received increasing attention in the literature and in the popular press and makes a good ending discussion point. Chapter Concepts LO1. The board of directors and corporate management must decide what to do with the firm’s annual earnings: pay them out as dividends or retain them for reinvestment in future projects. LO2. Dividends may have positive or negative information content for shareholders. Dividend policy can also provide information about where the firm is on its life cycle curve. LO3. Many other factors also influence dividend policy such as legal rules, the cash position of the firm, and the tax position of shareholders. LO4. Stock dividends and stock splits provide common stockholders with new shares, but their value must be carefully assessed. LO5. Some firms make a decision to repurchase their shares in the market rather than increase dividends. Annotated Outline and Strategy I. The Marginal Principle of Retained Earnings A. Life cycle growth and dividends B. The corporate growth rate in sales and earnings is a major influence on dividends. C A firm's dividend policy will usually reflect the firm's stage of development. 1. Stage I -- small firm, initial stage of development -- no dividends. 2. Stage II -- successful firm, growing demand for products and increasing sales, earnings and assets -- stock dividends followed later by small cash dividends. 3. Stage III -- cash dividends rise as asset expansion slows and external funds are more readily available -- stock dividends and stock splits also common. 4. Stage IV -- the firm reaches maturity and maintains a stable sales growth rate and cash dividends tend to be 40-60 percent of earnings depending on the industry. PPT Life Cycle Growth and Dividend Policy (Figure 18-1) Perspective 18-1: The life cycle curve is important. The impact of growth on cash flow ties back to cash forecasting in Chapter 4, and external and internal funds in Chapter 14. Be sure to emphasize the accelerating, decelerating, and constant growth areas. D. Dividends as a Passive Variable - According to the passive residual theory of dividends, earnings should be retained as long as the rate earned is expected to exceed a stockholder's rate of return on the distributed dividend. E. An Incomplete Theory - The residual dividend theory assumes a lack of preference for dividends by investors. F. Arguments for the Relevance of Dividends - Much disagreement exists as to investors' preference for dividends or retention of earnings. Arguments for the relevance of dividends ignore investor preferences but include: 1. Resolves investor uncertainty about receiving dividends. 2. Information content: “The firm must be doing well because it paid a dividend.” 3. A bird in the hand is worth two in the bush. In other words a known dividend is better than an unknown capital gain. II. Dividend Stability A. Firms with high growth rates usually pay relatively low dividends. See Table 18-1. B. Mature firms follow a relatively high payout policy. C. The average payout of U.S. corporations since WW II has been 40 to 50 percent of after tax earnings. D. The stable dividend policy followed by U.S. corporations indicates that corporate management feels that stockholders have a preference for dividends. PPT Corporate Dividend Policy (Table 18-1) Perspective 18-2: Figure 18-2 highlights the nature of retained earnings for the economy as a whole as companies preserve dividend payouts. PPT Corporate Profits, Dividends, and Retained Earnings (Figure 18-2) III. Other Factors Influencing Dividend Policy A. Legal rules -- most states have enacted laws protecting corporate creditors by forbidding distribution of the firm's capital in the form of dividends. B. Cash position-the firm must have cash available regardless of the level of past or current earnings in order to pay dividends. C. Access to capital markets- the easier the access to capital markets, the more able the firm is to pay dividends rather than retain earnings. D. Desire for control 1. Small, closely-held firms may limit dividends to avoid restrictive borrowing provisions or the need to sell new stock. 2. Established firms may feel pressure to pay dividends to avoid stockholders' demand for change of management. E. Tax position of shareholders 1. High tax-bracket stockholders may prefer retention of earnings because they can choose when to sell and pay taxes on their capital gain. They may also prefer retention of earnings over dividends when tax rates on dividends are higher than long-term capital gains taxes. 2. Lower tax-bracket individuals, corporations receiving dividends, and taxfree institutional investors such as pension funds may prefer higher dividend payout ratios. 3. See Table 18-3 for the new tax rates on dividends and capital gains under the American Taxpayer Relief Act of 2013. Notice that the table distinguishes between ordinary dividends and qualified dividends. IV. Dividend Payment Procedures A. Dividends are usually paid quarterly. 1. Dividend Yield = Annual dividend per share ÷ Current stock price. 2. Dividend Payout Ratio = Annual dividend per share ÷ Earnings per share B. Three key dividend dates: 1. Holder of record date-the date the corporation examines its books to determine who is entitled to a cash dividend. 2. Ex-dividend date-two business days prior to the holder of record date. If an investor buys a share of stock after the third day prior to the holder of record date, the investor's name would not appear on the firm's books. 3. Payment date-approximate date of mailing of dividend checks. V. Stock Dividends - - An additional distribution of stock shares, typically about 10 percent of outstanding amount. PPT XYZ Corporation's Financial Position before Stock Dividend (Table 18-4) PPT XYZ Corporation's Financial Position after Stock Dividend (Table 18-5) A. An accounting transfer is required at fair market from retained earnings. The par value of the stock dividend is transferred to the common stock account and the remainder (if any) is added to the capital in excess of par account. B. Unless total cash dividends increase, the stockholder does not benefit from a stock dividend. C. Use of stock dividends 1. Informational content-retention of earnings for reinvestment 2. Camouflage inability to pay cash dividends D. Reverse stock splits have an opposite impact: to lower the number of shares outstanding (as well as earnings per share) but to increase stock price. VI. Stock Split -- A distribution of stock that increases the total shares outstanding by 20-25 percent or more. PPT XYZ Corporation Before and After Stock Split (Table 18-6) A. Accounting transfer from retained earnings is not required. Par value of stock is reduced and the number of shares increases proportionately. B. Benefits to stockholders, if any, are difficult to identify. C. Primary purpose is to lower stock price into a more popular trading range. VII. Repurchase of Stock as an Alternative to Dividends A. Alternative to payment of dividends 1. Most often used when the firm has excess cash and inadequate investment opportunities. 2. With the exception of a lower capital gains tax (preferential tax treatment of capital gains was eliminated by the tax Reform Act of 1986) the stockholder would be as well off with a cash dividend. B. Other reasons for repurchase 1. Management may deem that stock is selling at a very low price and is the best investment available. 2. Use for stock options or as part of a tender offer in a merger or acquisition. 3. To reduce the possibility of being "taken over." PPT Financial Data of Morgan Corporation (Table 18-7) Finance in Action: IBM Repurchases Common Stock Worth Billions of Dollars. This article discusses IBM’s policy to repurchase common stock instead of paying large dividends. It also presents other reasons why other firms may follow this policy. PPT Recent examples of share repurchase announcements (Table 18-) VIII. Dividend Reinvestment Plans A. Begun during the 1970s, plans provide investors with an opportunity to buy additional shares of stock with the cash dividend paid by the company. B. Types of plans 1. The company sells treasury stock or authorized but unissued shares. The stock is often sold at a discount since no investment banking or underwriting fees have to be paid. This plan provides a cash flow to the company. 2. The company's transfer agent buys shares of stock in the market for the stockholder. This plan does not provide a cash flow to the firm but is a service to the stockholder. C. Plans usually allow stockholders to supplement dividends with cash payments up to $1,000 per month in order to increase purchase of stock Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 28, Montgomery Corporation (Dividend Policy) Case 29, Orbit Chemical Co. (Dividend Policy; This case also considers stock repurchases and stock options) 19 Convertibles, Warrants, and Derivatives Author's Overview Because the material in the chapter can be viewed from both a corporate finance and investments perspective, the student's interest in the chapter is usually quite high. The student is given an in depth exposure to convertibles, with primary attention devoted to valuation procedures. There is also material on the usefulness, advantages, and disadvantages of convertibles to the corporation. Many real world examples are included in the text and can be woven into the lecture. Accounting considerations related to SFAS #128 are covered using step-by-step procedures for computing basic and diluted earnings per share. The discussion of warrants parallels many of the points considered under convertibles. The topic of leverage, as it applies to warrants, also is appropriately introduced at this point and provides valuable background material for the student who progresses to subsequent courses in investments. We provide a brief introduction to options and futures in a corporate finance context. We discuss put and call options and focus on employee stock options which may be of interest to those students entering the job market. Futures are presented in combination with corporate hedging activities using oil and currency futures. Chapter Concepts LO1. Convertible securities can be converted to common stock at the option of the owner. LO2. Because these securities can be converted to common stock, their value may move with the value of common stock. LO3. Convertible bonds have a pure bond value based on interest paid and the market demanded rate of return. LO4. Warrants are similar to convertibles in that they give the warrant holder the right to acquire common stock. LO5. Accountants require that the potential effect of convertibles and warrants on earnings per share be reported on the income statement. LO6. Derivative securities such as options and futures can be used by corporate financial managers for hedging activities. Annotated Outline and Strategy I. Convertible Securities A. A convertible is a fixed income security, bond, or preferred stock that can be converted at the option of the holder into common stock. (The chapter focuses on convertible bonds.) 1. Conversion ratio: number of shares of common stock into which the security may be converted 2. Conversion price: face value of bond divided by the conversion ratio B. Value of the Convertible Bond 1. Conversion value: conversion ratio times the market price per share of common stock 2. Conversion premium: market value of convertible bond minus the conversion value 3. Pure bond value: the value of the convertible bond as a straight bond (non- convertible bond); the present value of the annual interest payment and maturity payment discounted at the market rate of interest 4. Investors pay a conversion premium if the price of the convertible security exceeds the value if the conversion were exercised. 5. If the market price of the common stock exceeds the conversion price, the market value of the bond will rise above its par value to the conversion value or higher. 6. The convertible bond's value is limited on the downside by its pure bond value, which is considered the “floor value." PPT Price Movement Pattern for a Convertible Bond (Figure 19-1) Perspective 19-1: Students often get confused about where the data come from for plotting these lines. The instructor should emphasize the relationship between common stock value and conversion value and the meaning of pure bond value. The conversion value line is easy to draw; you start at zero and pick any stock price then multiply by the conversion ratio and connect the two points. The pure bond value is a horizontal line representing the bond value without conversion features. PPT Pricing Pattern for Convertible Bonds Outstanding, Prices - January 28, 2013 (Table 19-1) Perspective 19-2: Use Table 19-1 to discuss discounts and premium to the pure bond value when the convertible bond is selling at a premium to par value, close to par value, and at a discount to par value. Comparisons can also be made between coupon rates and yields to maturity. C. Is this Fool’s Gold? Disadvantages to the Investor 1. All downside risk is not eliminated. When the conversion value is very high, the investor is subject to significant downward price movement. 2. The pure bond value will fall if interest rates rise. 3. Interest rates on convertibles are less than on nonconvertible straight bonds of the same risk. 4. Convertibles are usually subject to the call provision. D. Advantages and Disadvantages to the Corporation 1. Lower interest rate than a straight bond 2. May be only means for the company to gain access to the capital market 3. Enables the sale of stock at higher than market price 4. The size of the convertible bond market is relatively small. 5. Firms that use convertibles are usually smaller companies experiencing rapid growth and low dividend yields with low credit ratings and high risk PPT Characteristics of Convertible Bonds, January 28, 2013 (Table 19-2) E. Forcing Conversion 1. Conversion may be forced if the company calls the convertible when the conversion value exceeds the call price. 2. Conversion is encouraged by a "step-up" provision in the conversion price. Perspective 19-3: After covering the advantages and disadvantages of convertibles from both the investor and the corporate viewpoint, examine the trade-offs that are made by both parties. Probe students’ understanding of why a security like this exists and how it affects the capital structure and the cost of capital. PPT Successful Convertible Bonds and Preferred Stock not yet Called, February 5, 2013 (Table19-3) Perspective 19-4: Use Table 19-3 to show that companies do not always force conversion even when they could do so. The reasons usually focus on the fact that interest is tax deductible while dividends are not. So the company will consider whether the increased dividend payments that would occur with conversion are more costly than paying the interest on the bond. F. Accounting Considerations with Convertibles 1. Prior to 1969 the possible dilution effect of convertible securities on earnings per share was not required to be reflected in financial reports. 2. Currently earnings per share must be reported in two ways: Earnings after taxes Basic earnings per share = Shares of common stock PPT Diluted Earnings Per Share, XYZ Corporation (Table 19-4) Reported earnings plus interest savings after taxes Diluted earnings = Shares outstanding + All convertible securities where convertible securities include warrants, other options and any convertible securities that create common stock. PPT Diluted Earnings Per Share Equation (Formula 19-2) II. Financing Through Warrants A. A warrant is an option to buy a stated number of shares of stock at a specified price over a given period. 1. Sweetens a debt issue by lowering the interest rate on the bond 2. Usually detachable from the bond 3. Speculative: the value is dependent on the market movement of the stock PPT Relationships Determining Warrant Prices (Table 19-5) B. Valuation of Warrants I (= M −E) N 1. Applying this formula, the minimum value of a warrant may be found where: I = intrinsic value of a warrant M = market value of a common stock E = exercise price of a warrant N = number of shares each share entitles the holder to purchase 2. The actual price of the warrant may substantially exceed the formula value due to the speculative nature of warrants. 3. Table 19-6 demonstrates the speculative use of warrants to magnify a change in the stock price. C. Use of Warrants in Corporate Finance 1. Enhances a debt issue by giving the bondholder an option to buy the company’s stock at a set price. 2. Add-on in a merger or acquisition 3. Cannot be forced with a call, but option price is sometimes "stepped-up." 4. Equity base expands when warrants are exercised but the underlying debt remains. PPT Market Price Relationships for a Warrant (Figure 19-2) D. Accounting Considerations with Warrants - Potential dilution of earnings per share upon exercise of warrants must be disclosed in financial reports. III. Derivative Securities A. Call options are similar to employer stock options in that it is an option to buy securities at a set price for a specified period of time. B. A put option is the opposite of a call option. A put allows the put holder to sell shares to the put writer at a set price for a specified period of time. C. Futures contracts give the owner the right but not the obligation to buy or sell the underlying security or commodity at a future date. D. Derivatives can be used for speculation as well as hedging. Corporations generally use derivatives to hedge risk. Perspective 19-5: The instructor should emphasize that the use of derivatives is one of the most important developments in finance and that they can be used to hedge almost any type of risk. PPT Review of Formulas Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 30, Hamilton Products (Convertibles) Case 33, Security Software, Inc. (Convertibles) External Growth through Mergers 20 Author's Overview The discussion of mergers and acquisitions brings together a number of topics discussed earlier in the text. The instructor is able to take a second look at earnings per share growth, price-earnings ratios, stockholder wealth maximization, and portfolio considerations. These topics are considered in the present existing merger environment. Most students enjoy hearing about unfriendly takeovers, proxy battles, White Knights and various defensive strategies. A central consideration in the chapter is the effect of differential P/E ratios on post merger earnings per share. Once this concept is understood, the student should be encouraged to consider why P/E ratios may differ for the acquiring firm and the merger candidate. At least one major variable affecting P/E ratios is the possibility of differential future growth rates. Through numerical analysis, the student begins to see that the short-term impact on earnings per share can be very different from the long-term effect. Of greater importance, the student is forced to consider what the impact of these short and long-term effects will be on the post merger valuation. Another important consideration is the portfolio effect associated with the merger. The price movement pattern associated with mergers is also worthy of consideration. Not only is the material of interest to students who relate well to investment oriented subjects, but it is also an important consideration to corporate financial management. The premium offered and the associated price movement may determine management's strategy with regard to accepting or fighting a proposal. This is particularly relevant in the latest merger movement in which unfriendly offers for undervalued assets are commonplace. Chapter Concepts LO1. Firms engage in mergers for financial motives and to increase operating efficiency. Tax benefits and other factors must also be considered. LO2. Companies may be acquired through cash purchases or by one company exchanging its shares for another company's shares. LO3. The potential impact of the merger on earnings per share and stock value must be carefully assessed. LO4. The diversification benefits of a merger should be evaluated. LO5. Some buyouts are of an unfriendly nature and are strongly opposed by the potential candidate. Annotated Outline and Strategy PPT Largest Acquisitions Ever (Table 20-1) I. Motives for Business Combinations A. Business combinations may be either mergers or consolidations. 1. Merger: A combination of two or more companies in which the resulting firm maintains the identity of the acquiring company. 2. Consolidation: Two or more companies are combined to form an entirely new entity. B. Financial Motives: It is often cheaper to acquire market share than it is to develop it. 1. Risk reduction as a result of the portfolio effect a. Lower required rate of return by investors. b. Higher value of the firm. 2. Improved financing posture a. Greater access to financial markets to raise debt and equity capital. b. Attract more prestigious investment bankers to handle financing. c. Strengthen cash position and/or improve debt/equity ratio. 3. Obtain a tax loss carry forward, although the tax Reform Act of 1986 placed limitations on this process. C. Non-Financial Motives 1. Expand management and marketing capabilities. 2. Acquire new products. 3. Synergy: 2 + 2 = 5. D. Motives of Selling Stockholders 1. Desire to receive acquiring firm's stock which may have greater acceptability in the market. 2. Provides opportunity to diversify their holdings. 3. Gain on sale of stock at an attractive price. 4. Avoid the bias against smaller businesses. Finance In Action: Are Diversified Firms Winners or Losers? This is an interesting presentation about the merits of buying a diversified company or creating an equal portfolio. What does the stock market see in the benefits or penalties of diversification? Perspective 20-1: Mergers provide an opportunity to re-examine valuation models, cost of capital and capital budgeting techniques from previous chapters. Concepts of growth and value are relevant as are future benefits derived from the acquired company. II. Terms of Exchange A. Cash purchases 1. Capital budgeting decision: Net present value of purchasing a going concern equals the present value of cash inflows including anticipated synergistic benefits minus cash outlays including adjustment for tax shield benefit from any tax loss carryforward. 2. Many firms were purchased for cash in the 1970s and 1980s at a price below the replacement costs of their assets, but the rising stock market of the 1990s has made this difficult to duplicate. Even after the stock market retreat in 2000 and early 2001, companies are still selling well above replacement costs. B. Stock-for-Stock Exchange 1. Emphasizes the impact of the merger on earnings per share. 2. If the P/E ratio of the acquiring firm is greater than the P/E ratio of the acquired firm, there will be an immediate increase in earnings per share. 3. Stockholders of the acquired firm are usually more concerned with market value exchanged than earnings, dividends, or book value exchanged. PPT Financial Data on Potential Merging Firms (Table 20-2) 4. In addition to the immediate impact on earnings per share, the acquiring firm must be concerned with the long-run impact of the merger on market value. 5. An acquired firm may have a low P/E ratio because its future rate of growth is expected to be low. In the long run, the acquisition may reduce the acquiring firm's earnings per share and its market value. 6. The acquisition of a firm with a higher P/E ratio causes an immediate reduction in earnings per share. In the long run, however, the higher growth rate of the acquired firm may cause earnings per share and the market value of the acquiring company to be greater than if the merger did not take place. 7. Determinants of earnings per share impact of a merger a. Exchange ratio b. Relative growth rates c. Relative size of the firms PPT Post-Merger Earnings per Share (Table 20-3) PPT Risk-Reduction Portfolio Benefits (Figure 20-1) Perspective 20-2: The portfolio effect pertaining to mergers reinforces concepts learned in Chapter 13. Issues of earnings correlation and synergy can be discussed and, if possible, you might present a current merger situation with potential benefits and drawbacks. C. Portfolio Effect 1. If the risk assessment of the acquiring firm is decreased by a merger, its market value will rise even if the earnings per share remain constant. 2. Two types of risk reduction may be accomplished by a merger. a. Business risk reduction may result from acquiring a firm that is influenced by an opposite set of factors in the business cycle. b. Financial risk reduction may result from a lower use of debt in the post-merger financial structure of the acquiring firm. III Accounting Considerations in Mergers and Acquisitions A. Prior to December 2000, a merger was treated as either a pooling of interests or a purchase of assets on the books of the acquiring firm. After December 6, 2000 pooling of interests was no longer allowed. B. Criteria for pooling of interests treatment before December, 2000. 1. The acquiring firm issues only common stock, with rights identical to its old outstanding voting stock in exchange for substantially all the voting stock of the acquired company. 2. The acquired firm's stockholders maintain an ownership position in the surviving firm. 3. The merged firm does not intend to dispose of a significant portion of the assets of the combined companies within two years. 4. The combination is effected in a single transaction. C. Purchase of assets 1. Necessary when the tender offer is in cash, bonds, preferred stock, or common stock with restricted rights. 2. Any excess of purchase price over book value is recorded as goodwill and written off over a maximum period of 40 years (with some exceptions). 3. Before the accounting change goodwill had to be written off over a maximum of 40 years. This caused a negative effect on postmerger earnings. Under the new rules, goodwill does not have to be written off unless there is a verifiable decrease in the value of the acquired firm. IV. Negotiated versus Tender Offers A. Friendly versus unfriendly mergers 1. Most mergers are friendly and the terms are negotiated by the officers and directors of the involved companies. 2. Goodwill. During the 1970s and 1980s, takeover tender offers have occurred frequently and many proposed mergers have been opposed by the management of candidate firms. B. Unfriendly takeover attempts have resulted in additions to the Wall Street vocabulary 1. Saturday Night Special - a surprise offer made right before the market closes for the weekend. 2. White Knight - a third firm that management of the target firm calls upon to help avoid the initial, unwanted tender offer. 3. Leveraged takeover - the acquiring firm negotiates a loan based on the target company's assets (particularly a target company with large cash balances). C. Actions by target companies to avoid unwanted takeovers. 1. White Knight arrangements. 2. Moving corporate offices to states with protective provisions against takeovers. 3. Buying up company's own stock to reduce amount available for takeover. 4. Encouraging employees to buy stock under corporate pension plan. 5. Increasing dividends to keep stockholders happy. 6. Staggering election of members of the board of directors. 7. Buying other firms to increase size. 8. Avoiding large cash balances which encourage leveraged takeover attempts. Finance in Action: Why CEOs Like the Merger Game This box discusses an interesting byproduct of corporate mergers: Although each company has an executive team prior to a merger, only one CEO remains after most mergers. In order to induce the departing CEO to go through with the merger, a large “golden parachute” may be provided. This box may be worth discussing in the context of agency theory first presented in Chapter 1. V. Premium Offers and Stock Price Movements: The acquiring firm typically pays a merger premium of between 0-60 percent over the pre-merger market price of the firm being acquired. Perspective 20-3: Table 20-4 demonstrates what happens to the price of the acquisition target when the merger fails. This is a good example showing the premium between the preannouncement price and the day after announcement and the subsequent collapse of the stock price to below the preannouncement price. There is risk in speculating on mergers. VI. Two -Step Buyout A. The acquiring firm attempts to gain control by offering a very high cash price for 51 percent of the outstanding shares of the target firm. Simultaneously, a second lower price is announced that will be paid, either in cash, stock, or bonds at a subsequent point in time. B. One problem with merger premiums is they usually disappear if the merger is called off. C. The procedure provides a strong incentive for stockholders of the target firm to quickly react to the offer. Also, the two step buyout enables the acquiring firm to pay a lower total price than if a single offer is made. D. The SEC is keeping a close watch on the two-step buyout because of fears that the less sophisticated stockholders may be at a disadvantage when competing against arbitragers and institutional investors. E. The discussion of the 3M acquisition of Ceradyne shows how a company can technically avoid a two-step buyout and create the same price for all tendering stockholders. Other Chapter Supplements Cases for Use with Foundations of Financial Management Case 31, Acme Alarm Systems (Merger Terms and Stock Price) Case 34, National Brands versus A-1 Holdings (Merger Analysis) Case 35, KFC and the Colonel (Overall Business Considerations) 21 International Financial Management Author's Overview The instructor should stress the importance of international financial management (and international trade) to the class. The students can easily appreciate the everyday events that bring the world closer together. An important point is that international finance has the same elements as domestic financial management only the issues tend to be more involved. The firm must not only make a profit on a transaction, but convert that profit into the appropriate currency in a satisfactory manner. With the U.S. becoming a mature economy, it is increasingly important that students understand how to conduct business across international borders. The rise of the euro as a world currency has changed the way Europe does business. With 160 countries in the World Trade Organization, international trade will continue with the WTO trying to maintain an even playing field. While we have attempted to integrate international material throughout the book, this chapter concentrates only on international issues and is a good introduction to the complexities of international financial decision making for those instructors wanting more depth in this area. Chapter Concepts LO1. The multinational corporation is one that crosses international borders to gain expanded markets. LO2. A company operating in many foreign countries must consider the effect of exchange rates on its profitability and cash flow. LO3. Foreign exchange risk can be hedged or reduced. LO4. Political risk must carefully assessed in making a foreign investment decision. LO5. The potential ways for financing international operations are much greater than for domestic operations and should be carefully considered. Annotated Outline and Strategy I. Introduction A. Many factors have contributed to greater economic interaction among the world's nations. 1. Advances in communication and transportation. 2. Adaptation of political systems. a. Post World War II rebuilding programs b. European Common Market c. NAFTA 3. International flows of capital and technology. 4. International currency: U.S. dollar vs. the euro. 5. Interdependence for scarce resources. B. International business operations are complex and risky and require special understanding. PPT One U.S. Dollar to the British Pound and Euro (Figure 21-1) PPT International Sales of Selected U.S. Companies (Table 21-1) II. The Multinational Corporation (MNC): Nature and Environment A. Basic forms of MNC 1. Exporter -- exportation to foreign markets of domestically produced products. 2. Licensing Agreement -- granting of a license to an independent local (in the foreign country) firm to use the "exporting" firm's technology. 3. Joint Venture -- cooperative business operation with a firm (or firms) in the foreign country. 4. Fully Owned Foreign Subsidiary B. International Environment versus Domestic Environment 1. More risky -- in addition to normal business risks, the MNC is faced with foreign exchange risk and political risk. The portfolio risk of the parent company, however, may be reduced if foreign and domestic operations are not correlated. 2. Potentially more profitable. 3. More complex -- the laws, customs, and economic environment of the host country may vary in many respects: a. Rates of inflation b. Tax rules c. Structure and operation of financial institutions d. Financial policies and practices e. Work habits and wages of laborers III. Foreign Exchange Rates A. To facilitate international trade, currencies must be exchanged. For example, an exporter will usually desire payment in the currency of his home country. The importer must swap his domestic currency for the currency desired by the exporter in order to pay his bill. 1. Examine Figure 21-2 and some of the currencies vs. the dollar. 2. Currencies are not stable over time. Perspective 21-1: Use Figure 21-2 to show how currencies move up and down over time. PPT Exchange Rates to the Dollar (Figure 21-2) B. Factors affecting exchange rates 1. Supply of and demand for the currencies of the various countries. 2. The degree of central bank intervention. 3. Inflation rate differentials (Purchasing Power Parity Theory). 4. Interest rate differentials (Interest Rate Parity Theory). 5. Balance of payments 6. Government policies 7. Other factors a. Capital market movements b. Changes in supply of and demand for the products and services of individual countries c. Labor disputes C. Many variables affect currency exchange rates. The importance of each variable or set of variables will change as economics and political conditions change throughout the world. D. Spot Rates, Forward Rates, and Cross Rates Perspective 21-2: There are a number of easily understood examples in the text on spot and forward rates as well as cross rates. 1. Spot rate -- the exchange rate between currencies with immediate delivery 2. Forward rate -- the rate of exchange between currencies when delivery will occur in the future. 3. Cross rates -- the exchange rate between currencies such as Danish krone and British pounds based on their exchange rate with another currency such as U.S. dollars. PPT Key Currency Cross Rates (Table 21-2) IV. Managing Foreign Exchange Risk A. Three types of foreign exchange risk exposure 1. Accounting or translation exposure -- depends upon accounting rules established by the parent company's government. Under FASB #52, all foreign currency denominated assets and liabilities are converted at the rate of exchange in effect on the date of balance sheet preparation. 2. Transaction exposure -- in the U.S., foreign exchange gains and losses are reflected in the income statement for the current period -- this increases the volatility of earnings per share. 3. Economic Exposure to different county GDP performance. Perspective 21-3: The instructor might wish to discuss the different ways foreign exchange risk can be reduced. B. There are three strategies used to minimize transaction exposure: 1. Hedging in the forward exchange market -- the recipient (seller) of foreign currency in an international transaction sells a forward contract to assure the amount that will be received in domestic currency. 2. Hedging in the money market -- the recipient borrows foreign currency in the amount to be received and then immediately converts to domestic currency. When the receivable is collected, the loan is paid off. 3. Hedging in the currency futures market -- futures contracts in foreign currencies began trading in the International Monetary Market (IMM) of the Chicago Mercantile Exchange on May 16, 1972 and on the London International Financial Futures Exchange (LIFFE) in September, 1982 Finance in Action: Coca-Cola Manages Currency Risk As a large MNC, Coca-Cola, with over $50 billion in sales, must manage billions of dollars in currency risk. Coke uses 72 functional currencies along with the U.S. dollar. The company uses derivatives to manage these risks. One of the critical elements the firm uses to determine its hedging needs is the amount of accounts receivable outstanding in each currency. This box demonstrates that the primary use of derivatives is to reduce risk exposures, rather than to speculate. V. Foreign Investment Decisions A. Reasons for U.S. firms to invest in foreign countries 1. Fear of import tariffs (in foreign countries) 2. Lower production costs particularly with regard to labor costs 3. Ease of entry because of advanced American technology 4. Tax advantages 5. Strategic considerations -- competition 6. International diversification PPT Risk Reduction from International Diversification (Figure 21-3) B. Foreign firms are expanding their investment in the United States 1. Foreign investments in the United States provide employment for millions of people. 2. Reasons for foreign expansion in the U.S. a. International diversification b. Strategic considerations c. Increasing labor costs d. Saturated markets e. Shortage of land for development f. Large market in U.S. g. Labor restrictions overseas h. Access to advanced technology i. Political stability Perspective 21-4: This is a good place to talk about current political risk. C. Analysis of Political Risk 1. The structure of the foreign government and/or those in control may change many times during the lengthy period necessary to recover an investment. "Unfriendly" changes may result in: a. Foreign exchange restriction b. Foreign ownership limitations c. Blockage of repatriation of earnings d. Expropriation of foreign subsidiary's assets 2. Safeguards against political risk a. A thorough investigation of the country's political stability prior to investment. b. Joint ventures with local (foreign) companies c. Joint ventures with multiple companies representing multiple countries. d. Insurance through the federal government agency, Overseas Private Investment Corporation (OPIC). VI. Financing International Business Operations A. Letters of credit -- in order to reduce the risk of non-payment, an exporter may require an importer to furnish a letter of credit. The letter of credit is normally issued by the importer's bank and guarantees payment to the exporter upon delivery of the merchandise if the specified conditions are met. B. Export credit insurance -- a private association of 60 U.S. insurance firms, the Foreign Credit Insurance Association (FCIA), may provide insurance against nonpayment by foreign customers. C. Funding of transactions 1. Export-Import Bank (Eximbank) -- facilitates the financing of U.S. exports through several programs. 2. Loans from the parent company or sister affiliate. See Figure 21-4. a. Parallel loans -- an arrangement where two parent firms in different countries each make a loan to the affiliate of the other parent. The procedure eliminates foreign exchange risk. b. Fronting loans -- loans from a parent firm to a foreign subsidiary via a bank located in the foreign country. See Figure 21-5. 3. Eurodollar loans -- loans from foreign banks that are denominated in dollars. a. There are many participants in the Eurodollar market from throughout the world particularly the U.S., Canada, Western Europe and Japan. b. Lower borrowing costs and the absence of compensating balance requirements are significant incentives for U.S. firms. c. The lending rate is based on the London Interbank Offered Rate (LIBOR). d. Lending in the Eurodollar market is almost exclusively done by commercial banks. Large Euro-currency loans are frequently syndicated and managed by a lead bank. 4. Eurobond market -- long-term funds may be secured by issuing Eurobonds. These bonds are sold throughout the world but are denominated primarily in U.S. dollars. a. Disclosure requirements are less stringent. b. Registration costs are lower than in U.S. c. Some tax advantages exist. d. Caution must be exercised because of the exposure to foreign exchange risk. 5. International equity markets -- selling common stock to residents of a foreign country provides financing and also reduces political risk. Perspective 21-5: The instructor may wish to indicate the importance of international equity markets in the current age of the MNC. a. Multinational firms list their shares on major stock exchanges around the world. Half the stocks listed on the Amsterdam stock exchange are foreign. b. Marketing securities internationally requires firms to adjust their procedures. For example, commercial banks have a dominant role in the securities business throughout Europe c. Over 200 Foreign companies are listed on the NYSE. d. American Depository Receipts (ADRs) are a common way for foreign firms to list shares in the U.S. Finance in Action: Political Risk in Argentina This box provides an opportunity to discuss the risk of expropriation. The government of Argentina decided to expropriate the assets of the country’s largest oil company, YPF, which was a subsidiary of the Spanish multinational firm Repsol. While not mentioned in this discussion, the professor can bring up Venezuela’s expropriation of U.S. oil company assets. 6. International Finance Corporation (IFC) -- the IFC was established in 1956 and is a unit of the World Bank. Its objective is to promote economic development in the 119 member countries of the World Bank. a. A multinational firm may be able to raise equity capital by selling partial ownership to the IFC. b. The IFC decides to participate in the venture on the basis of profitability and the potential benefit to the host country. c. Once the venture is well established, the IFC frees up its capital by selling its ownership interest. VII. Unsettled Issues in International Finance A. The complexity of the multinational business environment generates questions for which there are no easy answers. 1. Should a foreign affiliate design a capital structure similar to that of the parent firm or one that fits the acceptable pattern of the host country? 2. Who should determine the dividend policy of a foreign affiliate -- the affiliate management or the parent management? B. Successful participation in the international business environment requires cohesive, coordinated financial management. VIII. Appendix 21A: Cash Flow Analysis and the Foreign Investment Decision Perspective 21-6: The appendix represents a reasonably complicated consideration of a foreign investment decision by a corporation. Because adequate coverage requires an hour or more, it is relegated to the appendix. PPT Cash Flow Analysis of a Foreign Investment (Table 21A-1) A. Cash Flow Analysis B. Tax Factors C. Foreign Exchange Considerations D. Present Value Analysis E. The Risk Factor Instructor Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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